Supply of Money & Banking

Money Supply
Described as the multiple of the monetary base, called money supply multiplier
Monetary base = Bank Reserves + Currency That is, MB = R + CU Money Supply = Deposits + Currency
That is, M = D + CU

Money multiplier is the ratio of the stock of money to the stock of monetary base

Deriving Money Multiplier

Step I: Divide the definition of the monetary base by deposits MB / D = (R/D) + (CU/D) = rd + cu Step II: Divide the definition of the money supply by deposits M/D = (D/D) + (CU/D) = 1+ cu Step III: Take the ratio of step II to step I and substitute the definition of cu and rd M = [(1+cr)/(rd+cu)] MB Step IV: This leads to m, the definiton of money supply multiplier m= [(1+cr)/(rd+cu)]

Implications
Money multiplier is larger the smaller the reserve ratio Money multiplier is larger the smaller currency deposit ratio

How has it been effected?

Currency deposit ratio depends to a larger extent upon the cost, convenience of obtaini cash, seasons, and so on Reserve ratio depends upon the Central Banks requirements Thus, Central Bank influences monetary based through monetary policies

Instruments to control money supply

Open market operations Reserve requirements (CRR: 5.5% & SLR: 24%) Bank rate (6%) (but now repo rate: 8.5%; reverse repo: 7.5%) Intervention in forex market Intervention in credit market fixing quantum of credit

What is meant by money supply in the economy?

From July 1935, the concept of money supply has been compiled by the RBI It is the sum of currency with the public & the demand deposits with the banking system This is referred to as narrow money and denoted by M1

What is meant by money supply in the economy? .

There is also a concept of broad money introduced in 1964-65. This is also referred to as Aggregate Monetary Resources It is the sum of M1 & the time deposits with the commercial banks From 1970, several concepts related to money aggregates which came into effect are-

What is meant by money supply in the economy?

M1 currency with public + demand deposits with the banking system + other deposits with the RBI Narrow Money M2 M1+Post office savings bank deposits M3 M1+Time deposits with the banking system Broad Money M4 M3+Total Post office deposits (excluding national savings certificate)

Explanations
M1 excludes time deposits Argument is time deposits are income earning asset & hence illiquid M3 includes time deposit Argument is time deposits are income earning assets & people have acquired them by converting cash into time deposits for earning future interest income & hence some amount of liquidity is imparted to it

Explanations
M2 & M4 measures of money supply include post office savings & other deposits with post offices. Hence they are a part of liquid assets & must be a part of aggregate monetary resources But owing to certain problems not treated to be so.

Balance Sheet of RBI

A. Monetary Liabilities (ML) A1. Notes in circulation A2. Other Deposits: a. Deposits of quasigovt b. Balance in the accounts of foreign central banks & governments c. Accounts of international agencies A3. Deposits of Banks (Reserves)

Financial Assets (FA) A. Credit to government A1. RBI credit to the centre a. loans & advances from RBI to centre b. RBI holdings of treasury bills, dated securities, rupee & small coins A2. RBI credit to the State government: loans & advances to state govts

Balance Sheet of RBI contd

B. Non-monetary Liabilities (NML) B1. Capital account (Net Worth) a. Paid-up capital b. Statutory Reserve c. Contingency Reserve, etc B2. Government deposits B3. IMF a/c # 1 (since 1948) B4. Miscellaneous NMLs e.g/ RBI Employees Pension Fund, Provident funds ets

B. Credit to the commercial sector B1. Shares/Bonds of financial institutions B2. Ordinary debentures of the cooperative sector B3. Debentures of cooperative land mortgage banks B4. Loans to financial institutions B5. Internal bills purchased & discounted

Balance Sheet of RBI contd

C. RBI s gross claims on banks C1. Refinance of RBI to the banks C2. Fixed investment in commercial bank shares/bonds & debentures D. Net Foreign Assets D1. Gold coin & Bullion D2. Eligible foreign securities D3. Balances held abroad netted for balances in IMF A/c # 1 minus India s quota s subscription in rupees  Other Assets (OA) A. Physical Assets B. Others

Vault Cash
The RBI issues currency (notes of two & above) The Central Government also issues money in form of one-rupee notes, coins & small coins The RBI currency together with the government money with the commercial banks is treated as Vault Cash

High Powered Money (H)

The RBI money together with the Government money constitutes the monetary base which is known as High Powered Money . High Powered Money = Money liabilities of RBI
+ Government money = Currency with public (C) + Reserves (R) + Other deposits with RBI = C+R (neglecting the other deposits with RBI) Where Reserves (R) vault cash + banks deposits with the RBI = Statutory reserves + Excess reserves Note: GM is negligible & bulk of H is made up of money liabilities of RBI

High Powered Money (H) looked at alternatively

RBI Assets = RBI Liabilities (FA)RBI + (OA)RBI = (ML)RBI + (NML)RBI (1) (FA)RBI + (OA)RBI - (NML)RBI = (ML)RBI ... (2)
Let Net Non-monetary Liabilities (NNML) of RBI be defined as

(NNML) RBI = (NML)RBI (OA)RBI ..(3) Using (3) in (1), (FA)RBI - (NNML) RBI = (ML)RBI Now, H = (ML)RBI + GM H = (ML)RBI + GM H (ML)RBI = (FA)RBI - (NNML) RBI (4)

Money multiplier for M3

In its simplest form Ms = m.H (5) Where m is the money multiplier & Ms is the broad money (M3) Now, M3 = C + DD + TD m = Ms/H = (C + DD + TD)/(C+R) = (C + DD + TD)/[C+(DD+TD)r] Where r = Reserve ratio = R/(DD+TD) m = {1+C/DD+TD/DD}/{C/DD+r(1+TD/DD)} = (1+c+t)/[c+r(1+t)] where c= C/DD & t = TD/DD

Money multiplier for M1

M1 = C +DD & R = r. DD Thus, money multiplier is m = (C+DD)/(C+R) m = {(1 + C/DD)}/{C/DD+r.(DD/DD)} m = (c+1)/(c+r)

Basic algebraic equations of broad money

Ms = (1+c+t)/[c+r(1+t)]. H
(considering the influence of TD)

Ms = (c+1)/(c+r) . H
(without the influence of TD)

What happens to money multiplier if banks hold excess reserves than required?

Let the excess reserve be E & excess reserves/DD ratio to be e m = (1+c)/(r+c+e) Ms = (1+c)/(r+c+e).H

Question
some extracts from the BS of the Central Bank Items Rs. In crore 1. Bank deposits 100 2. Government deposits 50 3. Foreign exchange assets 25 4. Net worth 1800 5. Other non-monetary liabilities 25 6. Credit to Government 1500 7. Credit to commercial sector 550 8. Gross claims on banks 800 9. Other assets 75 Assume government money is negligible

Question .
From the above balance sheet of the Central Bank, calculate 1. Monetary base 2. The required reserve ratio to arrive at a money supply of Rs. 4000 crore (given currency deposit ratio = 0.3) 3. Impact of an open market sale of government securities by Rs. 100 crore on the money supply

Answer
Show the liabilities and assets separately and find out the ML = 975 High Powered Money = 1075 Required money supply = 4000
4000 = m * H m = (1+cu) / (cu + rd) = (1+.3) / (.3+r) 4000 = [(1+.3) / (.3+r)] * 1075 = 3.72 3.72 (.3+r) = 1.3 .3+r = .349 r= .349-.3=.049 or 4.9%

Answer
If the Central bank sells Govt. sec, it will reduce H by 100 cr
Keeping all other variables same, money supply will come down 975 * 3.72 = 3627

Concept of Sterilization
Inflow / outflow of forex creates imbalances ; affects the assets of the central bank and so the high powered money Depending upon the inflationary situation, the central bank needs to follow either contractionary (reducing money supply) or expansionary (increasing money supply) policies Resorting of the central bank to these polices to correct for the imbalances created by changes in forex assets is known as sterilization

Question
B/S Items Government Money Credit to commercial sector Notes in circulation Credit to Government Statutory and Paid up capital Government deposits Gross claims on banks Foreign exchange assets Other non- monetary liabilities Physical assets Rs. In crore 60 1500 250 850 1200 350 600 550 75 115

Question .
Given the currency deposit ratio of 3 % and reserve deposit ratio of 5 % a. Calculate the money supply in the economy b. What will be the new reserve ratio if an additional inflow of FDI of Rs. 100 Cr has to be 50 % sterilized?

Answer
a. 25750 = (1.03/.08) * 2000
(ML = 1940; GM = 60) b. 27037.5 = (1.03/1.08) * 2100 Therefore 50% of change in money supply = 27037.5-25750 = 1287.5 / 2 = 643.75 Therefore 257540 +643.75 = 26393.75 Hence reserve ratio = 26393.75 = (1.03/r+.03) * 2100 12.56 (r + 0.03) = 1.03 r + 0.03 = .082 r= 0.052 or 5.2 %